Market Routs, Corrections and Sell Off

Share market sell offs are frightening for investors. The current global rout extends to commodities and currencies, adding to a perception of crisis. Yet markets rarely go anywhere in a straight line, and pullbacks are a natural part of market behaviour. In deciding how to respond to the current market moves, investors must answer the key question: “Is this a pullback, or the beginning of a crisis?”

The difficulty with the latest moves is there is no single trigger – there’s no Greek succession talks, no natural disaster, no outbreak of hostilities in economically sensitive parts of the world. Instead there are a number of influences that appear to have driven simultaneous global selling. The two most commonly cited are China growth concerns and an imminent US rate hike.

These investment themes are not new to market thinking. The US Federal reserve has explicitly foreshadowed a US rate hike since December last year, and made very clear the “normalisation” of US interest rates will be a slow and considered process, possibly taking years. Despite this unusually straight forward messaging, some think the possibility of a 0.25% lift is driving market selling. The current extension of this theme has a higher USD decimating emerging market economies, and dragging global growth backwards.

China slow down fears are also hardly new. A “hard landing” for the Chinese economy is a long standing theme, particularly among European and North American analysts. The more than 50% fall in industrial commodities such as copper, oil and iron ore over the last year reflect bearishness over the outlook in China. Commentators have seized on the latest monthly read on manufacturing as the trigger for the latest woes, but it’s more likely global investors are influenced by wild volatility of the Shanghai Composite Index.

Stocks in China are down more than 36% in just two months. An inconvenience to the bear case is the fact the Shanghai index rose 300% over the preceding twelve months. Nevertheless, when markets are in full panic mode a cool-headed explanation of the facts rarely helps. Further supporting the irrational investment case is the sell off that occurred when Chinese authorities moved to stimulate the economy – usually taken as a positive by share investors. The current version of the “China woe” story is that the share market sell-off has occurred in the face of nine different policy changes - meaning that the effectiveness of policy responses is now in question.

The focus on worst case scenarios is a good indicator of current market thinking. In the near term, this is likely to mean bad news is bad news, and good news is bad news.

Given a US economy in clear recovery, better than expected growth in Europe and a disconnect between China share markets and the underlying economy, it may be argued the current sell off has little to do with economic fundamentals. Perhaps more relevant is the fact that US shares indices have risen without a correction (10% or greater) since the first quarter of 2012 – an unusually long bull run.

Investor responses will depend on their view. Those who believe the world IS ending should panic now. For everyone else, the investment timeframe could be the key. Those who are taking the long view may choose to ride out the current pullback, particularly since the Australian index is already down more than 16% from highs hit earlier this year. Similarly, portfolio protection strategies employing CFDs or options may not be optimal given the size of the falls already. Of course, those who enacted such strategies earlier in the year may consider lifting their hedges.

Selling in panic is usually indiscriminate – as the old market saying goes “even pretty girls get hurt in a bus smash”. Many investor portfolios are narrowly focussed on a few sectors or stocks. Now is the time to diversify into those attractive shares that in the past seemed too expensive.

Traders must acknowledge the changed trading conditions. Volatility is up across the board - 20 day volatility in the Australia 200 index spiked from 14% last week to 23% today. Studies of volatility show that once periods of higher volatility begin, they persist. Trading strategy should reflect these changed conditions. Adaption may include more ambitious profit targets, stop loss levels further away from entry, smaller positions and shorter trade lives, depending on an individual's trading plan.

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